Quizmaster, Doug Hutchinson, presents his quiz for the month. Here, Doug discusses a strategy for getting a higher after tax yield.
Consider this Scenario:
Your friends George and Kathy are analyzing the holdings in their taxable joint account. They own $100,000 of an ETF that holds taxable bonds. This ETF has a yield of 2.30%. Assume George and Kathy have a federal tax rate of 28% and a state tax rate of 5%.
George and Kathy are considering replacing the taxable bond ETF with a municipal bond ETF that has a yield of 1.85%. Assume that the dividends for this municipal bond ETF are exempt from Federal and State taxes.
Does it make sense for George and Kathy to replace the taxable bond ETF with the municipal bond ETF in their taxable joint account?
It probably makes sense to replace the taxable bond ETF with the municipal bond ETF in their joint account because the municipal bond ETF has a higher taxable equivalent yield.
To determine if the tax savings of the municipal bond ETF makes up for its lower yield, we need to calculate the taxable equivalent yield of the municipal bond ETF:
Taxable Equivalent Yield = Tax Exempt Municipal ETF Yield / (1 - [Federal Tax Rate + State Tax Rate (1 – Federal Tax Rate])
Taxable Equivalent Yield = 0.0185 / (1 – 0.28+0.05(1 – 0.28))
Taxable Equivalent Yield = 0.0185 / 0.684
Taxable Equivalent Yield = 2.7%
In other words, George and Kathy would have to earn a 2.7% from a taxable bond ETF to offer an equivalent after tax yield of the municipal bond ETF.
As part of this analysis, George and Kathy should also consider the credit quality and duration of the municipal bond ETF to determine if they are taking on any additional risk by swapping into the municipal bond ETF. They should also consider the liquidity of each ETF and any trading costs associated with making this change. George and Kathy should consider working with a financial advisor to help them with a complete analysis of this potential change.
This quiz is intended for informational and illustrative purposes only. This material is not intended to be relied on as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The information presented is general information that does not take into account your individual circumstances, financial situation or needs, nor does it present a personalized recommendation to you. The information and opinions contained in this material are derived from sources deemed reliable, are not all-inclusive and are not guaranteed as to accuracy.
The information presented by WrapManager, Inc. is general information only and does not represent tax or legal advice, either expressed or implied. You are encouraged to seek professional tax advice for income tax questions and assistance. WrapManager, Inc. does not advise on any income tax requirements or issues.